Insurance Funds Gain as Pensions Flock to Untested Risks

Funds specializing in insurance-linked risks such as catastrophe bonds are benefiting as the $30
trillion pension industry increases bets in a market that hasn’t
posted an annual loss.

At Leadenhall Capital Partners in London, assets under
management have doubled to $1.6 billion this year with more than
90 percent coming from pension funds. Nephila Capital Ltd.,
manager of the world’s biggest fund of insurance-linked
securities, or ILS, has seen assets under management triple in
the past five years to about $9 billion.

The ILS market, which includes catastrophe coverage that
was traditionally provided by reinsurers, may reach an all-time
high of $50 billion this year and $150 billion by 2018 according
to a Bank of New York Mellon Corp. report. Expansion is fueled
by funds looking beyond asset classes like government bonds that
have been paying near record-low yields, said Bill Guffey, chief
underwriting officer at the special risks unit of Allianz SE. (ALV)

“Pension funds are merely dipping their toes in the
water,” Guffey said. “While part of the growing demand from
that sector is most likely due to the lack of viable
alternatives to invest your money, the limitation for further
growth is more on the supply side, from insurers seeking
coverage, than investors’ demand.”

In a catastrophe bond, insurers pay for protection against
events like hurricanes or earthquakes. Investors get above-market yields for taking the risk that their principal could be
wiped out by a large enough disaster.

Beating Junk

Catastrophe bonds have delivered gains of 12.7 percent from
the end of September 2012, through Dec. 6, a period that
includes superstorm Sandy, according to the Swiss Re Cat Bond
Total Return Index, which tracks dollar-denominated securities.
That compares with about 8.6 percent for the $1.4 trillion of
U.S. junk bonds tracked by Bloomberg.

“Cat bonds have been set up to cover for events that
fortunately didn’t happen so far,” said Martin Bisping, head of
non-life risk transfer at Swiss Re Ltd. (SREN), the world’s second-biggest reinsurer. “The market has not been tested by the big
hurricane yet.”

Catastrophe Losses

Only about five of the more than 200 cat bonds sold
resulted in losses since the securities were introduced in the
1990s, Bisping said. Defaults were triggered by Hurricane
Katrina in the U.S. in 2005 and the 2011 tsunami in Japan. Sandy
last year caused losses of less than 20 percent of the principal
on two bonds, according Munich Re, the largest reinsurer.

The European Insurance and Occupational Pensions Authority,
the region’s top industry supervisor, said in its financial
stability report published today that ILS developments need
“close monitoring by supervisors.”

“The extensive usage of ILS tends to cloud the picture in
terms of understanding the risk transfer,” it said.

Franklin “Tad” Montross, chief executive officer of the
General Re reinsurance unit at Warren Buffett’s Berkshire
Hathaway Inc. (BRK/A), has said pension funds are too reliant on models
in evaluating risks and may flee the market if a natural
disaster leads to unprecedented losses. The models have “lent
an aura of credibility” to pricing, Montross said at a
conference in June. “Anyone who’s in the industry knows that
the models are always wrong.”

‘Solid Portfolio’

“A solid portfolio over the long term will have some
degree of losses,” said Joseph Higgins, who oversee funds at
New York-based TIAA-CREF, which has $542 billion in assets under
management including between $250 million and $500 million of
direct insurance-linked investments. “We would remain committed
to insurance-linked securities even after a major loss hitting
half of the market.”

Reinsurance protects primary carriers from the biggest
risks, and pension funds are attracted to the business because
of its low correlation to equity and bond markets. They can
invest directly in the securities or allocate funds to
specialist asset managers, such as Nephila Capital.

“Pension funds are highly committed to the asset class,
one of my investors even placed his money in a way that it
immediately gets reinstated after a catastrophe hit so he can
benefit from higher post-event prices,” said Luca Albertini,
London-based CEO of Leadenhall Capital Partners. “Insurers
seeking capital market protection will opportunistically switch
from cat bonds to collateralized reinsurance back and forth.”

Low-Risk Securities

In collateralized coverage, investors post low-risk
securities such as treasuries in a trust account backing a
contract arranged by a reinsurer. The collateral is paid to the
covered carrier if a pre-defined disaster occurs. In return,
investors receive a premium payment.

Funds invested in collateralized reinsurance have doubled
to about $22 billion in two years, according to Hannover Re,
which earns more than 10 million euros ($13.8 million euros) in
annual fees arranging the contracts for ILS funds. That compares
with about $18 billion of outstanding cat bonds.

‘Growing Demand’

“Collateralized reinsurance is less heavily focused on
U.S. catastrophe risks and can include diversifying risk
coverage, for example for Australia and other territories,”
said Henning Ludolphs, head of insurance-linked securities at
Hannover Re, the world’s third-biggest reinsurer. “It’s much
simpler to put in place than a catastrophe bond.”

Typically, collateralized reinsurance provides about $2
million to $5 million of coverage per contract and the figure
can be as high as $100 million according to Hannover Re. The
minimum figures for cat bonds are larger because of costs
including legal paperwork.

“Collateralized reinsurance can focus on more local
risks,” said Michael Stahel, fund manager and partner at LGT
Insurance-Linked Strategies in Pfaeffikon, Switzerland,
overseeing about 60 percent of its $2.7 billion of assets on
behalf of pension clients. “A Category 4 hurricane striking
Miami could potentially affect over 40 percent of all
outstanding cat bonds, yet it might only affect 20 percent of a
diversified portfolio of the collateralized reinsurance.”

Natural Disasters

Category 4 is the second-most severe in the five-step
Saffir-Simpson scale. Such storms have sustained winds of at
least 130 miles per hour (209 kilometers per hour).

Natural disasters affecting the U.S. such as Atlantic
hurricanes make up 74 percent of cat bonds issued, according to
Munich Re (MUV2) report on the market. The U.S. has the most expensive
catastrophe risks and the biggest market.

Catastrophe bonds have posted a positive return every year,
according to Swiss Re data going back a decade. Still, pension
funds are realistic about what could go wrong, according to
Barney Schauble, a managing partner at Nephila Advisors, a unit
of the Hamilton, Bermuda-based fund.

“They won’t be spooked when a catastrophe happens in an
asset class that has ‘catastrophe’ clearly marked on the
label,” he said.